"The Vol Market Finally Broke": A Quant Explains What Happened To The Market

By Charlie McElligott, managing director of cross-asset strategy at Nomura.

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The “grey swan” we all have spoken about for years—that being the absurd “tail wagging the dog” potential of VIX ETN market structure (inverse and leveraged products) AND the massive growth in “negative convexity” / “vol target” / “vol rebalancing” strategies to either generate extra income or “systematically allocate risk” (looks good in the prospectus, right?!) –finally “broke” the volatility market, and has now bled-through to the “underlying” spot equities market…as the short vol trade went “lights out.” 

The ETNs are the “patient zero” of this current market meltdown.  It is estimated that there was anywhere from ~$125mm to $200mm of vega / VIX futs to BUY on the close from the two main “short VIX” ETNs that rebalance daily (XIV and SVXY).  As S&P traded -50 handles AFTER the cash close from 4:00pm to 4:15pm into the market’s anticipation of the massive rebalancing of volatility (buy to cover) on the close, XIV then saw a delayed and terrifying ~-87 PERCENT move after the close, as some who owned XIV puts as crash protection sniffed this potential and speculated liquidation from the ETN, which is set per a rules-based system to buy back short vega after an 80% “crash trigger”(which again isn’t a certainty because they use a blend of 1st and 2nd month).  The asset pool nonetheless was seemingly / largely wiped-out and the note is guaranteed to “pay out” to their shareholders as set per their prospectus.  It is likely that this thing has indeed been “triggered” and will be forced to liquidate.  SVXY doesn’t have the firm 80% “trigger” but too is seeing its NAV “wiped out” and is trading ~-80% post-close as well.

The issue NOW is the pile-on going-forward across assets, as the systematic “short vol” community’s models are now completely toast, and they too will be forced to cover remaining “short vol” positions that didn’t trade today—i.e. BE PREPARED FOR A MAJOR VIX FOLLOW-THROUGH TOMORROW. 

VaR-based models need to be reset across all asset-class strategies, forcing further de-risking over the coming days and potentially weeks, as heads of funds and heads of risk try to figure out how much their models are forcing them to “gross-down.”  Shorter-term vol target / vol allocation strategies (think CTAs) and longer-term models like risk-parity and too will reset and “rebalance” their risk (lower) as realized vols are re-priced.  Structured products, annuities and other vehicles with built-in protection?  Also purging exposure on the vol reset.  Finally, it also shouldn’t be lost on the popularity of “short VIX” trades in the retail community, and the “butterfly flapping its wings” relationship to the recent melt-down in the crypto-currency space. 

The “white knight” of corporate buybacks (which by the way were running at 300% of volume today per a competitor as they were pumping the mandates to hold-up their stocks) will be extraordinarily tested with keeping the stock-market “propped up,” especially as the traditional active community is likely to back-away until there is a better sense on how this event shakes out… few will willingly be in there tomorrow prepared to catch this falling knife.

Cross-asset, the trickle-down of unwinds is clearly a focal point from here.  As noted two weeks back in the “Nomura Cross-Asset” piece, I’ve been focusing on the “risk” of positioning asymmetries with consensual “bearish rates” / “flattener” and “short USD” trades primarily, but too, crowded thematic equities position tied to the rates and USD trades (i.e. “long momentum” / “long tech / growth”).  

As such, the +7 Z-SCORE (relative to 90d move) today in the UST 2Y/ mongo bull-steepening seen in 5s30s (+7bps today, +17bps since Thursday) raises a “pain trade” red flag.  Single-stock equities clearly took a hit on the back of the index moves, as thematic trades like “long US high beta”--which was +8.1% YTD on Jan 26th—are now -1.5% YTD after trading down -7.1% the past two sessions alone.  The six-day move in US momentum longs has been -4 standard deviations (across all returns dating back to April ’13), only previously experienced during the “Flash Crash.” 

My model equity L/S portfolio experienced its worst day since the early Feb ’16 market-neutral unwind which occurred during the “great deflation scare.”  Net / net, it wasn’t pretty out there.

Buckle-up, because this move isn’t over yet.


philipat spqrusa Mon, 02/05/2018 - 22:08 Permalink

So the Fed, to quote Powell, was wondering how it would unwind its (Hidden from its Balance Sheet) Short Vol position. Now he has the answer......;-)

Meanwhile Gold and, even more so Silver (easier to do; smaller market) are being aggressively capped by the usual suspects. If they still need to manipulate PM's when all a round them is collapsing, doesn't that actually just prove that PM's are at the centre of the whole scheme? Just sayin....

In reply to by spqrusa

Automatic Choke NoDebt Tue, 02/06/2018 - 01:34 Permalink

I'm merely pissed.   I was holding VIX calls, barely out of the money, 2-3 month expiry, rolling them over every couple months, for the last couple years...sometimes I let it gap when work got too crazy.   Steady stream of losing, but every time I thought about it, it looked like a good bet.    Was empty for this.   Shit.

The bulk of my portfolio was ok, though....lots of cash, lots of defensive stuff.    Been missing the ride up, though.


(Edit - another couple of days like today and I'll renew my Valueline subscription and start buying worthwhile stuff again....)

In reply to by NoDebt

BigCumulusClouds spqrusa Mon, 02/05/2018 - 22:08 Permalink

The big decline we’re seeing happens when “the memo” dissemination becomes an issue. The swamp is so damn thick, is seems there is no way for Trump to clean it. The powers that be will bring the markets down to ruin Trump and to secure their grip over our nation. Trump must fire Mueller, Rosenstein, and perhaps Sessions as well. Bring in the military to protect himself and his family, and give a nationwide address about how the WTC buildings were blown up on nine eleven and how Mueller led the cover up. There is no time left to pussy foot around with these pieces of frecking filth.

In reply to by spqrusa

gregga777 JethroBodien Mon, 02/05/2018 - 22:59 Permalink

Yes, the Pentagon was hit by either an AGM-86B cruise missile or a QF-4 remote controlled drone. There is absolutely no way on God's Green Earth that a Boeing 757 hit the Pentagon. It's just not possible considering a large commercial airliners flight characteristics. Ground effect alone would prevent it from descending to such an absurdly low altitude at high speed. Also there were no 757 components (corrosion resistant steel landing gear beams, high-temperature metal jet engine cores, wing spars which would have sliced through the Pentagon like a hot knife through butter, etc.) at the crash scene. 

In reply to by JethroBodien

Jung gregga777 Mon, 02/05/2018 - 23:42 Permalink

Indeed, planes don't fly through a building (saw the second plane sticking out the other end as if they can fly through metal and concrete, which is nonsense). I read about the Alt-9/11 Commission and they figure it was complex thing between Mossad/Russian Mafia and neocons/Zionists in the US: quite possible!

In reply to by gregga777

Jung gregga777 Tue, 02/06/2018 - 00:27 Permalink

Indeed, planes don't fly through a building (saw the second plane sticking out the other end as if they can fly through metal and concrete, which is nonsense). I read about the Alt-9/11 Commission and they figure it was complex thing between Mossad/Russian Mafia and neocons/Zionists in the US: quite possible!

In reply to by gregga777

mr bear gregga777 Tue, 02/06/2018 - 07:59 Permalink

My wife's office was in Shirlington at that time -- three miles south of the Pentagon on 395. When she heard the plane go overhead, everybody there dashed to the windows to see what was happening. And there it was, plain as day. "My God, it's going to crash," everyone screamed in unison. Then it did.

Peddle your BS on 4chan, willya?

In reply to by gregga777

Noktirnal JethroBodien Tue, 02/06/2018 - 00:11 Permalink

Flight 93 was shot down. It wasn't the passengers taking over. That is just a bedtime story. A North Dakota Air National Guard "Happy Hooligans" F-16, launched from Langley Air Force Base, Virginia, intercepted the airliner over Pennsylvania. It was brought down with a single AIM-120. The fighter then returned to base.

I was there, at Langley AFB, when the F-16 launched and when it returned, sans AIM-120.

In reply to by JethroBodien

Noktirnal CatInTheHat Tue, 02/06/2018 - 01:43 Permalink

I don't know. I was an A1C AGE Tech on dispatch duty. I was called on the radio to pick up a weapons loader and his missile trailer. I dropped them off at the hangar where the NG F-16's were. We called it the "Alert Hangar". I was dispatched to pick him up later, after the F-16's returned. His trailer was short an AIM-120, and he told me that the F-16 returned short one AIM-120.

In reply to by CatInTheHat